A Tale of Six Cities

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When Erik Prusch joined Borland Software Corp. last year, his top priority was making the company profitable after two years of losses. Critical to achieving that goal was the relocation of company headquarters from Silicon Valley to “Silicon Hill,” otherwise known as Austin, Texas, where the company already had a research presence. “We built out too many facilities, and now we’re trying to get down to the critical few,” says Prusch. The move, which involved laying off most of the finance team in California and replacing them with 60 new employees in Austin, will save an estimated $6 million in annual real estate and labor costs, he says. And although rents are rising in Austin, Prusch is hopeful that the glut of new office construction he sees around him will give him good options for years to come. “The viability of managing long-term real estate costs looks good for us,” he says.

Few CFOs can say that. A frenzy of investment in commercial real estate — much of it by private-equity firms committed to a strong payback — coupled with little new construction has left many corporate tenants feeling squeezed. Nationally, rents have increased an average of 11 percent (close to 2000’s record 12 percent), and for trophy properties in major cities rents have doubled or even tripled.

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That means CFOs are “playing a central role in assessing real estate as a global portfolio — focusing not only on facilities but on how labor and operations might be redistributed to reduce costs and improve productivity,” says Sandy Apgar, senior adviser to The Boston Consulting Group. While companies don’t often relocate, their strategies for expansion or shifting back-office operations are now more likely to be influenced by real estate considerations. They are also more likely to rethink how much space they really need, as many adopt remote-work and desk-sharing arrangements.

If real estate is to be managed as a portfolio, then it’s clear that locations must be evaluated on a wide range of considerations. In some markets, such as Austin and Chicago, tenants still wield a surprising amount of power. There are also deals to be had in up-and-coming markets like Las Vegas and Charlotte, North Carolina, which offer tax breaks and other incentives to woo new business. In the hottest markets, namely New York and San Francisco, there is little room to negotiate, but the talent pool and power of proximity may justify the astronomical rates.

And even for those who are stuck in the high-rent districts, 2008 brings some hope. The advantage is likely to swing back to the tenant side, if only slightly, as new construction reaches the final stages in many big cities and private-equity owners face the prospect of leasing (or selling) at a discount if they can’t refinance short-term loans, many of which come due in the first quarter of 2008.

New York

As the biggest real estate market in the United States, with some of the most aggressive landlords, New York City is easily to blame for many of the recent trends. For one, rents in the metropolitan area climbed about 20 percent over the past year, likely the highest increase in the nation, according to Jeffrey Havsy at Property & Portfolio Research (PPR). With metropolitan-area vacancy rates the tightest in the country, rent for the toniest Class A space in Manhattan surpassed $200 per square foot this year. Those numbers mathematically boost the national average rent, and can have “an important psychological effect” as well, since “people base expectations on them,” says Sam Chandan, chief economist at Reis Inc., a national real estate investment research and analysis firm.

New York is also the home of many of the private-equity players that are skewing the laws of supply and demand across the nation. Goodwin Procter’s Alex Randall, a real estate attorney and head negotiator for the firm’s office space, experienced this firsthand last year. After six months of negotiations, he was on the verge of signing a lease for a former Equity Office Properties Trust (EOP) building in Manhattan when The Blackstone Group acquired the site and demanded a 20 percent increase in rent, amounting to $4 million annually. “They literally told me on the phone, ‘We spent a lot of money for this building, so we have to charge high rents,'” says Randall. “I’d never heard that logic before.” Months later, he was looking for space in San Francisco and found the same phenomenon, with rents doubling as buildings on his short list were acquired by New York private-equity firms like Broadway Partners and an arm of Merrill Lynch. “It was the same dynamic, with out-of-town funds and investors buying the office towers, holding them off the market, and raising the rent, irrespective of supply and demand,” says Randall.

Still, for certain industries, there is no substitute for New York connections and culture. Financial services, media, and advertising firms are among those that can’t afford to be elsewhere. For other companies, the benefits of New York’s talent pool outweigh the headaches of dealing with the tough real estate market. Since moving its headquarters to Manhattan from Cleveland four years ago, executive recruiting firm CTPartners (formerly Christian & Timbers) has been able to hire 25 new partners and increase its revenue fivefold, says CEO Brian Sullivan.

The tech industry is also making inroads into the city; both Google and Yahoo have opened research facilities there in recent years. Meanwhile, New York mayor Michael Bloomberg is pushing to make the city attractive to biotech firms. He offered more than $13 million in city funds to help build the new East River Science Park, which broke ground in mid-October, plus tax incentives worth more than $250 million over 25 years.

How to cope with the sky-high rents? Experts say you won’t find space for less than around $40 per square foot anywhere in the city, but you may be able to trim costs by moving around a bit. Randall ultimately found a bigger site at a 15 percent discount to his original deal by moving across town to the new New York Times building, in a less upscale area. More subleased space, which usually goes at a discount to current rates, may also become available if investment banks continue their layoffs as they retrench from subprime losses.

There is also some relief coming on the supply side; 6.2 million square feet of new space is expected in the next two years, and more after that, including the Freedom Towers, as the rebuilt World Trade Center will be known. For 2008, PPR forecasts that rents will rise by only 4 percent — a deal by New York standards.

Anchored by the corporate headquarters of Bank of America and Wachovia, Charlotte is the second-largest financial center in the United States after New York. Charlotte reigns supreme, however, when it comes to demand for office space: for the first three quarters of 2007 its downtown office-vacancy rate hovered around 3 percent, the lowest in the country, according to CB Richard Ellis. At the same time, Charlotte has seen an influx of out-of-town landlords. Steve Gassaway, head of CBRE’s Charlotte office, estimates about 40 percent of the downtown inventory has turned over in the past few years, pushing rents up by about 30 percent, to more than $30 per square foot in the better buildings. “We have seen cases where a landlord would rather have tenants leave than lower the rents and mess up expectations,” says John Stubbs, a broker with Jones Lang LaSalle. “But it hasn’t completely flipped to where it’s entirely a landlord’s market, either.”

For the most part, though, Charlotte is happy to steer clear of comparisons to Manhattan, since one of its big selling points is being “one of the cheapest places to live and to run a business,” says Jeffrey Edge, senior vice president of economic development for the Charlotte Chamber of Commerce. That, plus an educated workforce, an international airport, and good weather make it an attractive spot for everything from corporate headquarters to manufacturing facilities to back-office functions. (Fortune 500 companies that call Charlotte home include Duke Energy, Nucor, and Family Dollar.) Some 700 international companies, particularly ones based in Europe, also have operations in the area, thanks to Charlotte’s direct flights to the UK and Germany.

Incentives don’t hurt. Microban International got a $45,000 state grant, while digital-photo processor Shutterfly, based in Redwood City, California, received a $250,000 state grant and another $3.6 million in future tax incentives when it chose Charlotte as its East Coast hub.

For most companies in the area, the space crunch downtown is easily alleviated by moving outside the city center. Rents in the area near the airport, where Shutterfly chose to locate, are in the low-$20s per square foot, with “a nice product, and it’s not like you’re in the suburbs,” says Stubbs.

Still, as the central business district becomes more desirable, local officials are eagerly awaiting the 2.6 million square feet of new construction due on the market starting in 2009. “The lack of space downtown is probably what will hold us back the most in the next year or so,” says Edge. (Of course, some space may free up sooner, with both Bank of America and Wachovia announcing layoffs as part of the post-subprime fallout.)

With relatively high vacancy rates, decreasing demand, and a growing supply of space, Chicago is one of the few places that have been semi-immune to huge rent increases. It “has probably been the softest of any of the major markets for the longest time,” says Gerald Porter, chairman of corporate real estate advisory firm CresaPartners. That despite having 37 percent of its downtown space, including trophy buildings like the Sears Tower and the Civic Opera House, change hands for higher prices in recent years.

CME Group CFO James Parisi used that softness to his advantage when it came time to renew a lease for his company, which is the product of a recent merger between the Chicago Mercantile Exchange and the Chicago Board of Trade. When the company’s main building was acquired by Blackstone earlier this year, Parisi and his real estate consultant announced that they were moving out unless the new landlords agreed to complete a $25 million–plus renovation, with a minimum 10 percent decrease in rent. Despite its no-negotiation reputation, Blackstone complied, since the company “needed our lease to solidify the value of the building,” says consultant Holly Duran, of Holly Duran Real Estate Partners. That agreement was written into the terms when Blackstone later sold the property to Tishman Speyer, she says. Renovations are now under way.

Chicago also boasts a wide array of suburbs that are considered legitimate homes for business, with good public transportation and relatively cheap land to lure business outside the downtown area. The comparatively low property taxes in DuPage County, which borders the city, has made Oak Brook (home of McDonald’s and Federal Signal) particularly popular.

Still, the suburbs-versus-downtown decision “is driven by labor-force considerations more than anything else,” says Richard Schuham, executive vice president in Studley Inc.’s Chicago office. Motorola, Brunswick, CareerBuilder, and PepsiCo have all brought research, design, or marketing centers downtown in the past several years, and some old-line industrial companies are locating wholly in the downtown. United Air Lines Inc. moved there in 2006 from suburban Elk Grove Village and is now expanding, thanks in part to a package of incentives from the city that could total $15.5 million. USG Corp. received a similar package two years ago to keep its headquarters within city limits.

Assuming the credit crunch forces leveraged landlords to ease up, rents should come down by the second half of 2008, says Schuham. And 5.5 million square feet of new construction will become available between 2009 and 2012.

Back on its feet after the 2001 tech bust knocked it down, Austin has once again become “the new ‘it’ place,” says PPR’s Havsy, thanks in large part to its high rankings for quality of life, low cost of living, and the presence of the well-respected University of Texas, Austin. Longtime home to Texas Instruments, Freescale Semiconductor, and Dell, the Austin area more recently has welcomed operations or regional headquarters for some 118 new companies, according to the Greater Austin Chamber of Commerce.

As Borland’s decision illustrates, a highly skilled workforce is the top attraction. That’s especially true in high-tech and financial services, says Terence Spielman, head of PayPal’s new Austin operations. Spielman plans to hire 220 people in the next two years. The biggest challenge, says Dave Porter, senior vice president of the Greater Austin Chamber of Commerce, is that the population is relatively young and lacks a strong pool of top-level management. Zilliant Inc., a local software company, freely admits that it poaches such talent from bigger companies (which often have the means to relocate executives), even to the extent that “there’s a good possibility we’ll find [a CFO candidate] here” when the company is ready to hire one, says chief talent officer Laura Hauck.

Austin’s real estate market has not been immune to the private-equity effect. In fact, Blackstone flipped its portfolio of buildings there to Thomas Properties in June for $1.15 billion, a price that assumes rents will rise. Year to date, the cost of Austin’s Class A rentals has increased 7.6 percent, significantly higher than the national average of 5.2 percent, according to research firm Reis. And while “new companies coming in still find it a bargain,” says Porter of CresaPartners, some, such as Oracle and ArthroCare, are expanding outside the central business district, in part to save costs and make housing more affordable for employees.

On the positive side, Austin will rank among the top three cities in the nation for new commercial construction as a percentage of existing stock, according to PPR. That means rent increases should slow — in fact, PPR projects they will even drop slightly in 2009 as supply catches up with demand. And the city is strong on incentives, tapping the state’s sizable “deal-closing” fund to land Samsung’s new semiconductor plant and two Hewlett-Packard data centers.

With one of the fastest growing populations in the country, no corporate or personal income tax, and an international airport, Las Vegas seems an ideal shelter. Some 263 companies have located in southern Nevada since 2002, including computer maker CDW Corp., which opened a distribution facility in the area last year, and many alternative-energy companies, which have a ready-made market thanks to a state mandate that 20 percent of Nevada Power’s resources must come from nontraditional sources by 2015.

Still, “Sin City” has yet to become a corporate-headquarters haven for brand-name companies. One factor working against it is that office space is not exactly cheap, averaging $25.52 per square foot — more expensive than such cities as Austin and Charlotte. The mountains surrounding the city constrain the supply of developable land, and although construction is booming, office projects must compete with multi-billion-dollar resort projects for construction workers, driving up expenses, according to Matthew Kreft, an adviser at Grubb & Ellis Las Vegas. For bargains, Kreft steers companies toward the downtown central east submarket, where space in older buildings can be had for $24 per square foot. Go to a new building along the recently opened Central Las Vegas Beltway and rents approach $40 per square foot for top-tier space.

The lack of a stable and educated labor pool is another drawback. While the population is growing rapidly, only about half of the city’s 2 million residents are considered part of the labor force. Building a finance team there “would take some time,” says Lori Layton, who heads Ajilon Finance’s Las Vegas office. Salaries for accounting staff (and even CFOs) at gaming and hospitality companies tend to be lower than in other industries, she says, and the lack of other corporate options in Las Vegas makes nearby Phoenix and Southern California look more attractive to many job seekers, including mid- to high-level finance professionals.

Locals are doing their best to change the city’s image, though. “I think the stigma that we had at one time is for all intents and purposes gone; we’re seeing companies consider coming here that five years ago wouldn’t have talked to us,” says Somer Hollingsworth, president and CEO of the Nevada Development Authority. He points to the three-year-old Nevada Cancer Institute, which managed to recruit top-tier doctors from around the country, as “shatter[ing] the myth that smart people won’t move to Las Vegas.” Further positioning it as an area for medical research is the planned Lou Ruvo Brain Center, scheduled to move into its Frank Gehry–designed headquarters late next year. Las Vegas “has the capability to be a headquarters town,” provided that buildings get taller and nascent efforts to provide workforce training take off, says Kreft. “The only thing that could hinder future development is the availability of water.”

Sources: Reis Inc., U.S. Census Bureau, UNLV Center for Business & Economic Research

San Francisco

The good news is that San Francisco seems to be regaining its former eminence as a technology hub, with such companies as MySpace and Bebo.com joining Salesforce.com and Yahoo as major downtown tenants. Vacancy rates have dropped from 23 percent in 2002 to about 12 percent this year.

The bad news is that with the new presence of New York–based private-equity landlords like Broadway Partners and Morgan Stanley come rents in the $100 per-square-foot range, which haven’t been seen since the dot-com boom, when vacancy rates were below 1 percent. About 70 percent of the downtown buildings have been sold in the last two years, says Steve Barker, executive vice president at Studley, boosting rents 40 to 100 percent despite only a nominal increase in demand. “There’s a total disconnect between supply and demand,” he says.

One example of the new velocity: One Market, perhaps the toniest building in the city, had three owners within four months, passing from EOP to Blackstone to Morgan Stanley (which recently sold a 50 percent stake in the building to the Paramount Group). Rents for several vacant top floors have gone from $50 to $70 to $90 to $110 per square foot with each transaction, according to Barker. That has spurred some tenants to look for better deals: law firm Barg Coffin Lewis & Trapp decided to leave the building when rent would have doubled to $100 per square foot, and more companies are following suit. “It’s definitely a phenomenon that’s happening across the market,” says Barker. “There aren’t that many tenants that can afford to pay those prices.”

How to cope? Unlike Chicago, San Francisco has a fairly concentrated downtown area. Companies that try moving out to the East Bay or South Bay will save little on rent, though they will save the city’s 1.5 percent payroll tax, which can translate into a $5-to-$8-per-foot savings when applied to real estate, says Barker.

Most experts believe rents will come down to meet demand, but that it will take a while. PPR predicts that the rent growth will drop to about 4 percent in 2008 and 3 percent in 2009, as landlords swallow their pride and the supply of office space expands, with some 3.5 million square feet coming onto the market in the next two years. That means that if your lease is up this year, or growth is driving the need for more space, the best strategy may be to aim for a short-term deal and hope rents are more rational when it is time to renegotiate.

With office buildings changing hands so quickly, it’s pretty much impossible to avoid highly leveraged, rent-hungry landlords in New York, Los Angeles, San Francisco, or Boston. Here are a few tips for dealing with them.

Call the current tenants. Alex Randall, a real estate attorney with Goodwin Procter and head negotiator for the firm’s office space, recommends asking them how tough or generous the landlord is, since “that might dictate how detailed a term sheet you negotiate.”

Nitpick. Assuming the landlord is a financial buyer who likely isn’t looking to build a long-term relationship, Randall will drill down, clause by clause, into areas where owners typically nickel-and-dime tenants. Before any negotiations start, he says, it is important to ask about items like future increases for operating costs, the markups on after-hours air conditioning or freight-elevator use, and construction-oversight fees, looking for any chance to negotiate limits.

Consider Section 467. Tenants might also look for a bigger upfront tax deduction through this section of the tax code, which allows tax to be paid equally over the term of the lease even if rent is initially free — at the price of higher income taxes for the landlord.

Guard against landlord turnover. In this instance, the “critical factor is to have a very tight and artfully crafted subordination nondisturbance agreement,” says Robert L. Freedman, chairman of GVA Williams’s New York office. These agreements ensure that “no one can mess with your tenancy” during the term of your lease.

Envy the clever deal-makers. In smaller markets, at least one CFO has found a way to profit from the rise in commercial real estate. When wireless-equipment distributor and manufacturer Infosonics moved into a single-tenant office building in San Diego three years ago, CFO Jeff Klausner negotiated for both a cap on operating cost increases and an option to buy at a fixed price. This year, he was able to exercise that option and immediately turn the property over to another buyer, pocketing more than $2 million for Infosonics in the process. And, he is still saving $120,000 a year in rent by moving to a space in San Diego that was better suited for Infosonics’s headquarters, and relocating some operations to its facility in Miami. — A.S.